For the majority of house hunters out there you will end up choosing between an FHA home loan and a conventional home loan. Since this is one of the biggest decisions you will make financially, we will go through a recent loan experience so that you can make an informed and educated decision about your home purchase.
How Can The FHA Assist Me In Buying A Home?
One of our recent client’s stories.
Back in the spring of 2014, my wife and I bought a home in Atlanta. It was our second time buying a home, so we knew what to expect with the loan process and mortgage options facing us. Up till now we had used a conventional mortgage since our credit was pretty good.
We decided to try a different option and explore the FHA loan program. Since our credit score took a a hit due to having high balances on our credit cards and because of the 3.5% down payment and flexible credit score requirements, it seemed like a more reasonable option. Before we made this decision, we took the time to review the pros and cons of Conventional vs. FHA loans. We researched a few different mortgage sites and even talked with a few mortgage brokers to see what loan products would be the best fit.
THE FHA Loan
Simply put the FHA loan is a government insured loan from the Federal Housing Administration. When you go to take out a loan for this program, you have to do it through an FHA-approved lender.
FHA Loan Guidelines
- The borrower will need to take out mortgage insurance on the loan
- Lenders are insured against defaulting on the loan by the FHA
- The Primary borrower – must be able to document a solid 2 year history of employment, credit, and income. Also, the borrower will need to document or put down liquid assets for a down payment
- The Occupying co-borrower – must take title to the property and sign the note and mortgage documents
- The Co-Borrower must complete a loan application and a full underwriting of employment, income, and credit. The co-borrower will be qualified the same way as the primary borrower
- The Co-Borrower cannot be a person who is a third party to the purchase transaction: seller, realtor, builder, or appraiser
- For non-occupying borrowers or co-borrowers check with your mortgage advisor for more details on these guidelines as they vary a bit
Benefits of using an FHA loan include:
1. Less down payment required
When comparing FHA loans against conventional loans you will notice that you have to put at least 5% down-payment on a conventional loan. Depending on your credit score and financial history this can vary. This rule is one of the primary reasons that the FHA loan is so appealing to first time and even second time home buyers because of the low down payment requirement of 3.5%. This feature, on top of the FHA recently reducing their monthly MI by about 60% has made FHA a very popular choice again because of its affordability.
There are a few exceptions to the rule, though- if you served your country and received a certificate of eligibility you can qualify for no money down with a VA loan. Also, if you are purchasing in an area deemed rural and meet the income limits you may be eligible for a no money down USDA loan which also offers flexible loan guidelines. These loans are only available to particular types of borrowers so do your homework to see if you meet requirements.
2. Easier approval process than conventional mortgages
In general, it is simpler to qualify for an FHA loan compared to a conventional home loan. That said depending on your specifics like credit score, down-payment, debt to income ratio and how long you plan on being in the home, conventional may be a better option if you can qualify. Here’s why on FHA regardless of how much you put down you will have to pay mortgage insurance. Yes even if you put down 20%. Another recent change to consider is that the mortgage insurance on FHA loans is now part of your loan for the life of the loan regardless of equity. That means that to get rid of the mortgage insurance, you would need to refinance in the future once you have 20% equity. On the other hand, if you put down less than 20% on Conventional there are options for you not to pay monthly mortgage insurance.
This Lender Paid Mortgage Insurance program takes a slightly higher interest rate than you qualify for to avoid paying monthly mortgage insurance. Depending on your qualifying factors this can mean you end up with a lower fixed payment per month. The main difference between FHA and conventional mortgage insurance is that your mortgage insurance amount on conventional will be based on your credit score and down payment amount. On FHA it’s a one size fits all approach to paying mortgage insurance you’re either approved for the loan or not. This method of insuring mortgages all started after the housing crisis in 2008 when insurers took heavy losses on foreclosures.
3. More flexible guidelines for credit scores
We discussed this earlier on, but we need to expand on this subject. If your credit score falls below 640, there is a good chance that your application for a conventional loan won’t qualify. Even If if you are approved you may end up paying more for your mortgage than compared to an FHA loan. Since the 2008 housing crisis, private mortgage insurers have raised the cost for mortgage insurance on low credit scores for conventional loans, and this is why we are currently seeing a resurgence in the popularity of FHA loans.
One of the key benefits of the FHA loan is that you can get approved with a credit score as low as 600. If you have a moderate credit score be sure to consult with your trusted mortgage advisor to see which loan options will offer you the best terms for your unique situation.
Credit scores were in the middle range for my wife and me when we bought our home. We both had credit scores around 660. In this range, we qualified for either an FHA loan or a conventional mortgage. Ultimately it came down to which program could offer us the lowest fixed payment and the most affordable down payment.
4. More forgiving debt-to-income ratio
Part of the loan application process which the lender will want to review is the amount of debt-to-income ratio you currently have and if you can handle you new mortgage payments, property taxes and current debts.
The debt-to-income ratio compares your monthly earnings and how much of those earnings are going towards your debts. If your debts are too high, your chances of getting approved for your loan and how much home you can qualify for can be limited.
When comparing the FHA vs. Conventional loans, you will find out quickly that you can have a higher debt-to-income ratio available to you with an FHA loan. In some cases that can be as much as 55% with full approval. In the conventional loan the debt-to-income ratio is capped at 45%, so if you are higher than that percentage, then your loan will not be approved.
My wife and I had a ratio that was 41%, so it did not affect this part our application. It’s just crucial to try and reduce your debts as much as possible before applying, and it is the best advice I can give you since this is a major deciding factor in the loan approval process.
5. More forgiving of bankruptcy and foreclosure
One of the main benefits of an FHA Mortgage is that the program is more lenient about approving loans when you have had a previous bankruptcy, short sale or foreclosure. In most cases if (2) years have passed since a bankruptcy you’re more likely to be approved for an FHA loan vs. a Conventional Loan. It’s a (3) year wait from a foreclosure or short sale, just to be clear this starts from the date the property is sold. Conventional loans are less lenient about past foreclosures and bankruptcies making the period for approval longer and more restrictive. For example, in bankruptcy, you have to wait (4) years and (7) years from a foreclosure or short sale.
Think of an FHA loan as a second chance for responsible borrowers or an excellent option for first time home buyers that don’t have all their ducks in a row quite yet. I’d like to point out that the FHA program is not an easy route for irresponsible borrowers. It may be simpler to get approved for an FHA Mortgage vs.a Conventional Mortgage, but your financials still have to pass the mustard with the lender. Just keep in mind that if you decide to go the FHA loan route, you can be assured the mortgage lender will go through your financial situation with a fine tooth comb. They will make sure that you meet the FHA requirements discussed earlier. The lender will review your employment history over the past few years, debt to income ratio, income, and assets for your down payment.
The Conventional Mortgage Loan
The primary benefit of conventional loans is that if you have credit north of 680, you will likely end up with better terms. Even if you have less than 20% for a down payment, there are options for you to avoid paying monthly mortgage insurance mentioned earlier like Lender Paid Mortgage Insurance. At the end of the day, it comes down to down payment and credit score. If you have the luxury of 20% down and excellent credit you open yourself up to the most promising options available. Here is where it gets interesting when you compare the private mortgage insurance versus the government FHA mortgage insurance. in the majority of cases, the PMI is going to be much less on the conventional loan with 5% – 10% down and high credit than with the equivalent FHA loan which requires mortgage insurance for larger amounts and the life of the loan.
Government Mortgage Insurance versus Private Mortgage Insurance
If you don’t have a 20% down payment, the FHA loan looks like the best route to take on paper, and if you have a 20% down payment then the conventional mortgage is the best way right? The answer is a resounding no! It depends on what priorities matter the most to you for your current and future situation as well on these main factors: credit score, down payment, and debt to income ratio.
Do I put more money down 5% – 20% on a conventional loan and pay no mortgage insurance or a small amount of mortgage insurance each month?
Do I go for a lower down payment option like 3.5% with an FHA loan and pay more mortgage insurance each month?
So these answers are up to you and only you. Like most things in life, there are some trade-offs either way you go.
As for my wife and I, we ended up going to the smaller 3.5% down payment under the FHA program. The result when we compared each loan against each other with our mortgage advisor was the FHA loan had a lower overall amount compared to a conventional loan due to our lower credit score. If our scores would have been higher, then we would have gone with the Conventional loan option.
Now you know the pros and cons of FHA loans vs. conventional loans. As you can tell by now, choosing between an FHA loan and a conventional loan is not easy. Each situation is unique so do yourself a favor and consult with your trusted mortgage advisor to come up with a plan using your financial footprint.
You can always give us a call, apply online or schedule an appointment so we can go through the numbers together. That way you feel educated and informed before making this crucial decision in your life.